The United States of Envy: Redistribution vs. Economic Growth

In advance of the 2014 election, the Obama administration has drawn the political discussion away from its unpopular and flawed healthcare plan, usually called Obamacare, to bring public attention and support for increased income redistribution.

President Obama has openly encouraged envy of the top 1 percent of income earners. Reducing the share received by the highest earners to provide revenue for larger transfers to the lowest earners has long been a main objective of his administration. We can all expect this theme to be trumpeted loudly by the mainstream press as the mid-term election approaches: Some of us can have more, the argument goes, if we force others to have less.

Support for the alleged social benefits of setting much higher marginal tax rates on the highest incomes has now been offered by the International Monetary Fund, based heavily on research by two French economists named Thomas Piketty and Emanuel Saez. The two worked together on the faculty at MIT, where the current research director of the IMF, Olivier Blanchard, was a professor. Like Piketty and Saez, he too is French. France has, for many years, implemented destructive policies of income redistribution.

Professor Piketty collected data on income distribution from approximately 20 countries over periods of different length. He concluded that raising the tax rate to 60 percent on the highest incomes and redistributing the receipts to the poor would increase spending and economic growth. The New York Times declared his book, Capital in the 21st Century, one of the great achievements of modern economics. It put it in a class with Karl Marx’s Das Kapital and John Maynard Keynes’s General Theory.

Wrong Conclusion on Causality

This lavish praise seems both wrong and extreme. I agree that in the past there was a notable positive association between economic growth and the spread between the shares of income going to the top 1, 5, or 10 percent of the earners and the share going to the remainder. The mistake is to conclude that narrowing the distribution contributes to growth. The far more plausible explanation is that economic growth in capitalist countries over the past two centuries contributed to a steep decline in the share of the top earners.

Simply put, Piketty, President Obama, and the IMF have the causality running the wrong way. Taxing the rich to redistribute did not produce growth. On the contrary, growth reduced the share earned by the highest earners.

In my 2012 book Why Capitalism? I used some data on the share of income received by the top 1 percent that two Swedish economists gathered. Piketty uses some of the same data. The seven countries in the Swedish dataset are the United States, the United Kingdom, Sweden, Australia, France, Canada, and the Netherlands. Of course, data on income distribution are never precise, but broad trends can be informative.

The data show a remarkable degree of uniformity. The share of income received by the top 1 percent declined persistently from about 1910 to 1980. The share fell from an initial 20 to 25 percent of total income to about 5 to 8 percent. Then the share rose in several of the countries, notably the United States, the UK, Canada, and Sweden. By the end of the sample data, about 2005, the share in several of these countries was back to about 10 percent. The share of the top 1 percent in the United States reached 15 percent, more than halfway back to where it was early in the twentieth century. It is this rise that initiated the loud outcries about the failure of modern capitalism to benefit the middle class.

It is impossible for anyone to show that the decline in all seven countries resulted from higher taxes on the highest incomes and redistribution to the poor. The reason is that the welfare state did not exist in several of the countries and was relatively small in the others. In the United States, federal government spending was rarely more then 3 or 4 percent of total spending in non-war years until after 1930. Old age pensions didn’t start until the late 1930s, and healthcare spending did not expand until the late 1960s.

The timing in other countries differed. Sweden undertook welfare state spending in the 1930s, but substantial growth waited for the end of World War II. The same is true for most other countries. Higher tax rates and increased social spending rose long after the share of the top 1 percent had declined from the early peak to the trough in 1980. In 1980, the share of income earned by the 1 percent ranged from 5 percent in Sweden with its larger welfare state to 8 percent in the United States.

Decades of Shrinking Inequality

Two major forces explain most of the decline. At the start of the series, private capital receives a relatively high return because it is rather scarce. As investment and the capital stock rose during the twentieth century, the share of total income going to capital declined. The total income from capital increased but more slowly than total income. Since the highest-income earners receive a disproportionate share of their income as earning on capital, their share fell.

That alone does not explain the steep decline in the share received by the top 1 percent. During the early twentieth century, the United States absorbed millions of immigrants, many unskilled. Many began employment at low-wage jobs. Minimum wage laws were not passed until the 1930s. By working, the immigrants learned new skills; their productivity increased and with it their wages. That narrowed the gap between the incomes of the top and the bottom earners. But many did something else. They sent their children to colleges and universities where they learned professional skills that earned middle-class incomes.

This process continued in recent decades for immigrants from Korea, China, Mexico, and Latin America. That history sends an important message. The growth of the middle class and the narrowing of the income distribution was in large part a result of working to acquire new skills and higher productivity.

President Obama’s program works against this process. It doesn’t reward work. It gives the unemployed and underemployed food stamps, healthcare, housing allowances, and income. Instead of working, many learn to live on the government benefits, supplementing them occasionally by working in the underground economy. Instead of acquiring productive skills, they learn how to live without working at regular jobs. That’s one way that the welfare state worked to increase the share of the highest paid 1 percent after 1980. The welfare state contributes also by weakening and even destroying family structure. Single-family women are often on the bottom rung of the income distribution.

Importance of Human Capital

A different process is at work now. The capital that is most highly rewarded is now human capital—the education and skill that produces innovations such as the Internet, social media, popular apps, fracking, and three-dimensional manufacturing. The top 1 percent of the earners in any year include people like Steve Jobs and Bill Gates who made the Internet into a commercially successful, widely used means of communicating. But the top 1 percent also includes leading sports stars with unique skills and rock musicians with enormous popular appeal.

And what does Bill Gates do with his wealth? He spends much of it on improving healthcare in Africa and improving education in the United States. An example is the effort to provide bed nets to protect Africans from malaria, an outcome the public bureaucrats failed to achieve after decades of foreign aid.

The noisy political clamor about the rise in the share going to the top 1 percent gives no attention to the importance of education, skill, and an environment that encourages innovation. It is not an accident that most new products and much new music originates in the United States. Countries like Canada, Sweden, and the UK contribute also, welcoming foreign innovation and willing to reward those who bring new ideas to market successfully. And for reasons that the critics should explain, they do not include in-kind transfers and corporate payments for healthcare and pensions as part of the income of the employed.

What has worked in the United States for several centuries has worked well for many other countries in the past 50 years. Once China adopted capitalist methods, it moved millions out of low-productivity agriculture, taught them new skills, and raised their wages. Korea sends its young to learn new skills in the United States. That enabled it to move successfully from a low-wage provider of unskilled labor to a technically advanced country with a skilled labor force. And it increased freedom along with wealth. Other examples are Hong Kong, Singapore, and Taiwan—free, capitalist democracies. Add Chile, Peru, and Mexico among others.

The Fleeing French

France is at the opposite pole. Mired in its hatred of capitalism and demands for redistribution, it has maintained its low share of income going to the top 1 percent. But the cost is high. The young and innovative leave France for the UK and other shores. The French get massive redistribution and unemployment for many who remain behind.

Voters who will hear the Obama call for envy and redistribution should ask themselves and others: Would you prefer to live in an America where the market is dynamic and opportunity abounds, or in France, where unemployment is high and tax rates are crushing? Don’t you prefer opportunity to envy?

Allan H. Meltzer(am05@andrew.cmu.edu)is a distinguished visiting fellow at the Hoover Institution and the Allan H. Meltzer University Professor of Political Economy at the Tepper School of Business at Carnegie Mellon University. Professor Meltzer has served as a consultant on economic policy for the US Congress, US Treasury, the Federal Reserve, the World Bank, and the US and foreign governments and was chair of the International Financial Institution Advisory Commission. Used with permission of Defining Ideas, a Hoover Institution Journal: http://www.hoover.org/publications/defining-ideas/